DOCUMENTS

May 15, 2012

Contemplating the sale of a tract of land or commercial real estate, or even a personal residence? A property owner may want to consider taking action sooner rather than later.

There are two changes on the horizon that could significantly impact profits on residential, land and commercial real estate transactions: new Medicare surtaxes and the expiration of the Bush tax cuts.

The Patient Protection and Affordable Care Act (aka Obamacare) has been front and center in the news for the past couple of years, ever since it became law in March 2010. Buried within the nearly 3,000-page document were more regulations and taxes than most realized.

Consider Section 1411 of the bill, where the Medicare surtax is addressed. What does the healthcare bill have to do with real estate, one may ask?

For the first time, a 3.8% Medicare payroll tax will be applied to investment income – including rents and net gains from disposition of real estate – of single taxpayers with adjusted gross income above $200,000 and joint filers over $250,000.

One may think that this impacts only the very wealthy … It may be worth taking another look. Consider the small farmer or investor living on a meager income, but sells a tract of land or building that yields a capital gain of over $200,000. Is such a sale subject to the 3.8% tax?

Perform a Google search “The 3.8% Tax: Real Estate Scenarios & Examples” to find a detailed informational brochure available from the National Association of REALTORS® that lays out helpful scenarios calculating Medicare surplus taxes on a variety of real estate transactions.

According to the Realtors® association, “This new tax was never introduced, discussed or reviewed until just hours before the final debate on the massive healthcare legislation began.”

And that’s not all. The healthcare reform legislation also imposes an additional 0.9% hospital insurance tax on wages in excess of $250,000 for married taxpayers filing jointly and $200,000 for single taxpayers.

Assuming the Supreme Court doesn’t reject Obamacare in its entirety, both of these taxes take effect in 2013. Taxpayers in the highest brackets could see income tax increases of as much as 4.7% due to the Obamacare legislation!

The other grim reaper lurking in the shadows is the fast-approaching expiration of the Bush-era tax cuts. If those tax cuts expire at the end of this year, capital gains tax rates generally will increase from 15% to 20% (0% to 10% for lower-income). This increase affects all taxpayers, including small businesses.

“The bulk of these changes will affect individuals, but they will also have a major impact on businesses,” said Jennifer Fair, a certified public accountant with Frederick’s McLean, Koehler, Sparks and Hammond. “In particular, the highest income tax rate on individuals will increase to 39.6% percent, which is 4.6 percentage points higher than the highest tax rate on corporations. Therefore, although there has been a move in recent years toward pass-through entities, such as limited liability corporations, the C-corporation may again come back into favor as individual rates are increased.”

“We don’t expect any legislation on these tax cuts to be passed until after the election,” Ms. Fair continued. “We are planning as if they are expiring, until we hear otherwise. It is possible the legislation could be passed as late as early 2013 and made retroactive.”

So, what is the bottom line of all of these tax increases in the pipeline?

A real estate seller could be facing a combined increase in capital gains taxes of 8.8% next year!

“If all of this hits at the same time, it could send shivers up people’s spines,” said Bill Castelli, vice president of Government Affairs with the Maryland Association of REALTORS®. “It’s not clear what is going to happen in Congress. On one hand, Republicans want to hold out to extend the Bush tax credits, but they have to pass something. The election results will have a role to play in this, and the economy will have a role to play. If the economy doesn’t pick up so revenues can fund some of the deficit, it gives Congress less of a choice.”

So, what’s a seller of land and commercial real estate to do?

Sell that property before 2013. That’s the only sure way to avoid these taxes.

If that is just not practical, one may choose to wait (for what could be several years) for a more robust real estate market, it is highly recommended that one find a competent accountant or financial planner to help with capital gains planning. Tax planning strategies (including reporting capital gains on the sale of property on an installment basis) can help reduce or defer capital gains income.

An additional thank you goes out to Catharine Fairley, a certified public accountant and principal at Draper & McGinley, PA, for her guidance and expertise in providing information for this article.

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